New Zealand dairy farmers have been delivered a short-term setback with Fonterra Cooperative Group's cut to its forecast milk payout. Longer-term some of the gloss has come off as well.

They're grappling with the second spring season in a row where wet weather has hampered grass growth, followed by a record dry November for many parts of the country that could herald drought conditions. For the 2017/18 season, Fonterra has cut its forecast New Zealand milk collection by 1 percent to 1,525 million kilograms, meaning it sees no growth from last season's milk production. If anything, global dairy prices are even more volatile than the weather.

At $6.40 per kilogram of milk solids, the reduced forecast payout is still well above the current industry-estimated breakeven price of $5/kgMS, not to mention the 2015/16 season's dismal $3.90/kgMS payout.

But there are hints that New Zealand dairy's dream run is cooling in a longer-term sense. Net confidence among dairy farmers tumbled to 18 percent in the fourth quarter from 50 percent three months earlier, second only to the drop in confidence among horticulturalists, in Rabobank's Rural Confidence Survey. The bank said gloominess is linked to concern about "potential interventions" by the new coalition government that would make life tougher for farmers.

The government's policy aims may include ramping up restrictions on water use and runoff, setting higher hurdles for foreign buyers of farms and bringing agriculture into New Zealand's commitment to reducing greenhouse gas emissions to combat climate change.

Other anecdotes may underline a sense of dissatisfaction. The Real Estate Institute's rural market report for the three months ended Oct. 31 included the observation from REINZ rural spokesman Brian Peacocke that "early evidence emerged of the likelihood of record numbers of farms coming onto the market in the main dairying areas of Waikato and Southland." Sales of dairy farms in October were low - just five properties sold - and in the three-month period, the per-hectare sale price slipped to $40,012 from $40,716 a year earlier.

Peacocke calls it "a blip" that may reflect a combination of factors including selling by older farmers - it is an ageing demographic - and bad weather.

"There's a lot of frustration triggered by the extraordinary bad climatic conditions through the winter and spring that has tested everybody involved," he said. "We’ve not had that combination of factors for that period of time. In terms of some of the volume of property for sale, retiring parties will sell if they get the price they think they should get."

There are also longer-term factors at play, including growing concerns about the environment.

"The reality is that environmental issues are going to put a cap on things," Peacocke said. "It’s a peak in terms of the area in dairy. Production will increase through improvements in production, better techniques. I don’t think we'll see the same raft of dairy conversions - largely driven by environmental issues, particularly led by water. Water in terms of quality and quantity."

Consumers in export markets are helping drive change. Fonterra uses a Trusted Goodness logo on export products, which is designed to appeal to consumers who want sustainable and ethical practices in food production and is underpinned by New Zealand’s "natural, grass-fed advantage”. From September next year, it will penalise farmers who use excessive palm kernel expeller as a supplementary feed. That's partly a response to criticism of rainforest destruction but also because PKE changes the composition of fat in the milk and creates issues in terms of manufacturing and in meeting requirements of some markets.

ASB Bank senior rural economist Nathan Penny says while fluctuations in the volume of dairy farms on the market may not be significant, change is coming. "The numbers are small," he says. "You get three sales at a certain number and people start talking." Penny told attendees at the recent NZX dairy derivatives conference in Singapore that the next 10 years won't be like the decade just past.

"If we step back for a second, what we saw over the last 10 years was massive growth in the dairy sector. From 2000 to 2014/15 output almost doubled. A remarkable run of growth," Penny said. "Dairy had the whole agricultural sandpit to itself. Now in the past few years, there's been a lot more competition from other sectors. Horticulture has really come to the fore. Beef has really strengthened. Lamb prices are coming back to profitable levels for farmers. Viticulture and forestry have grown as well."

Dairy had "the run of the house. First choice of land, water, people, and capital. In the next 10 years, it’s going to have to compete with all those other sectors," he said.

Lenders bankrolled the growth in dairy and now debt levels on dairy farms are "reasonably high" but credit growth has slowed and other sectors are competing for capital, including increasingly profitable kiwifruit orchards. As dairy businesses have scaled up they've become more complex while at the same time, environmental regulation has loomed larger. Adding to that has been volatility in the milk price, which "has knocked people's confidence" in the last 3-4 years, Penny says.

Fonterra has adapted to changing market conditions, directing more milk to the value-add parts of its business but given its scale, it won't be able to completely shed its dependence on commodity dairy products and, by law, it is required to take all the milk its farmers produce - a massive increase in the past decade. It is likely to take in more milk in the next 10 years, even as its share of New Zealand's milk pool falls.

Penny said Fonterra is likely to become more aggressive in fighting for its share of milk production. "Now the pie isn't growing, I'm guessing they might try to put the squeeze on."

The global dairy market has also been changing. In particular, the European Union's decision in 2015 to scrap milk quotas that had been in place since 1984. The most efficient EU dairy countries - Ireland, the Netherlands, and Germany - gained the freedom to ramp up production, although the European Commission was quick to downplay concern that there would be a return to the days of stockpiled 'butter mountains'.

There's an ongoing debate about how that's changed the dynamics of the market.

"Once those quotas came off in Europe, they were pretty quick to respond when prices rose," said Susan Kilsby, a dairy analyst at NZX. "Europe never used to be able to respond at all because of the milk quotas they were given."

In cutting the milk payout forecast today, Fonterra chair John Wilson said that "despite demand for dairy remaining strong, particularly in China, other parts of Asia, and Latin America, we are seeing strong production out of Europe and continued high levels of EU intervention stockpiles of skim milk powder."

Back here in New Zealand, Kilsby says there is a sense that these are changing times with regulation on the rise and heightened focus on issues such as water quality.

"There’s a whole lot of uncertainty about how that is going to affect values," she said. "It's not clear-cut. It just feels like it is getting harder."

The biggest farms may be affected by tighter criteria the government plans to impose on the Overseas Investment Office. Currently, on Trade Me there's a Southland dairy unit of 1,363 hectares on sale for $38 million. It was listed on Nov. 10.

"Those big farms - it has been hard enough to get overseas approval – the time it takes for those big blocks to sell," Kilsby said. "Investment people are recognising that the capital gains run has come to an end. Farmers can no longer necessarily rely on land prices continuing to rise going forward."

(BusinessDesk)

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